By Dwight Cass
The move looks smart, but the first detailed measure to implement Dodd-Frank’s anti-ratings edict on an issuer-specific topic skirts the credit criteria issue.
The Securities and Exchange Commission removed all references to credit ratings from rules governing shelf registrations on July 26. The rule change was one of several initiatives the SEC has taken, or is in the process of taking, to satisfy section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires the commission to eliminate or reduce the role that Nationally Recognized Statistical Rating Organizations (NRSROs) play in its regulations.
But some observers warn that the move will do little to advance the goal of reducing the market’s dependence on Standard & Poor’s, Moody’s, Fitch and their smaller competitors—a goal with new impetus since S&P downgraded U.S. debt on August 5.
Dodd-Frank’s section 939A is meant to remove the government’s imprimatur on the NRSROs, thereby reducing the financial system’s need to rely on them. The danger rating firms still pose to the financial system was on August 8, when the S&P 500 dropped more than 6.6 percent. It was also on display in the late July chaos following S&P’s sudden withdrawal of ratings on commercial mortgage bonds, after discovering a flaw in its calculations.
Shelf Life
Previously, to qualify to use a shelf registration, an issuer had to have an investment-grade rating from one of the NRSROs. The SEC’s rule change in late July eliminated all reference to ratings in the short-form rules, replacing them with criteria that appear largely unrelated to credit (see sidebar below).
GETTING SHELVED
To qualify to offer non-convertible securities other than equity via a shelf registration (Form S-3 or F-3), an issuer must meet one of the following tests:
- The issuer has issued (as of a date within 60 days prior to the filing of the registration statement) at least $1 billion in non-convertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act, over the prior three years; or
- The issuer has outstanding (as of a date within 60 days prior to the filing of the registration statement) at least $750 million of non-convertible securities, other than common equity, issued in primary offerings for cash, not exchange, registered under the Securities Act; or
- The issuer is a wholly-owned subsidiary of a well-known seasoned issuer (“WKSI”) as defined in Rule 405 under the Securities Act; or
- The issuer is a majority-owned operating partnership of a real estate investment trust (“REIT”) that qualifies as a WKSI; or
- The issuer discloses in the registration statement that it has a reasonable belief that it would have been eligible to register the securities offerings proposed to be registered under such registration statement pursuant to General Instruction I.B.2 of Form S-3 or Form F-3 in existence prior to the new rules, discloses the basis for such belief, and files the final prospectus for any such offering on or before the date that is three years from the effective date of the amendments.
The new rules require companies wishing to use the short-form shelf registration to have issued at least $1bn in debt over the prior three years, or to have at least $750mn of registered debt outstanding, or to be a well-known seasoned issuer (WKSI) or the subsidiary of one.
While the SEC removed the investment-grade requirement, the new criteria simply push reliance on ratings back one level, allowing the SEC to say it is in compliance with Dodd-Frank. A corporate finance lawyer who lobbied the SEC on this issue noted, “The amount outstanding or how much you are able to issue is a function of your rating. This leaves the raters in control and the SEC off the hook.”
Giving WKSIs a pass also fails to reduce ratings reliance. After all, to qualify as a WKSI you must either have a market cap of $750mn or have issued $1bn of debt within the preceding three years. A company’s debt level is usually constrained to some extent by the desire to achieve some target cost of capital, which means maintaining its target rating. Investors’ endemic outsourcing of their credit research, in turn, drives the need for a target rating. As one treasurer said simply, “There’s no way we can publicly issue unrated debt.”
Credit to the Board
Leaving credit out of the shelf rules seems like a notable oversight until one looks at the alternatives. There aren’t many, as demonstrated by the SEC’s attempt to pull references to ratings out of its rules.
In early 2010, the SEC tightened its credit criteria (among other investment parameters) for money funds. In the post-Reserve Fund world this appeared to make sense. The SEC at the time announced that the new rules would continue to limit an MMFs’ investment in rated securities to those rated in the top two rating categories. It added that at the same time, the new rules would still require MMFs to perform independent credit analysis of all securities purchased. In this way credit ratings serve as “a screen on credit quality,” but can never be the sole factor in
determining if a security is appropriate.
Dodd-Frank forced the SEC to abandon that screen. Its March 2011 proposal to reduce money fund reliance on ratings per Dodd–Frank essentially boils down to: use your best judgment. Amendments to the Investment Company Act’s rule 2a-7 throw out any requirements for ratings firms to help determine the first- and second-tier investments that funds can buy.
In their place, the SEC decreed that a money fund could purchase an asset “only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer’s ability to meet its short-term financial obligations.”
To accomplish this will require credit analysis resources not typically demanded by money funds. But at least the SEC assigned responsibility for the credit analysis. In the shelf registration case, it appears to have simply washed its hands of the matter.